Forex Options Trading for Hedging Currency Risk
Posted on May 3 2012 at 11:54:17 AM in Finance & Investment
Author: Nelly Naneva, LL.M, MBF, Markets Weekly
Currency risk is part of the financial and operational risks associated with the possibility of adverse movement in the exchange rate of a particular currency relative to another. As compared to investments in local assets, the fluctuating foreign exchange rates represent an additional risk factor for traders who want to protect their portfolios. The control and management of foreign exchange risk is a substantial part of business management with a view to improve the efficiency of international investments. One generally accepted method for hedging currency risk is the Forex options trading. This article is concentrated on the practices of currency risk hedging and their efficiency to control foreign exchange risk through Forex options trading. (Hedging is any action or a set of activities, aiming reduction or neutralization of identified potential risks.)
The use of Forex options trading for exchange-rate risk management is nowadays widespread in developed economies; it is considered to be a routine part of the business of financial institutions and companies. By its nature, the currency option differs from the other types of options by its economic function; it hedges the exchange-rate risk and the underlying asset is a particular currency or set of currencies.
Options are derivatives, whose price is derived from the value of a particular underlying security, currency or commodity. Forex Options trading constitutes a conclusion of an agreement that gives the buyer the right, but not the obligation, to buy or sell the underlying asset (currency) at a strike price on or before a predefined future date when the option expires. In legal essence, the Forex options trading are provisional and fixed-term transactions. The deal is conditional, because it becomes effective only if the buyer desires. It is also a fixed-term agreement, because its execution is at some time in the future. Currency option is a financial asset like shares or bonds and constitutes a legally binding agreement between two parties with strictly defined terms and conditions.
There are two basic types of options. The buyer of a Call option owns the right, but not the obligation to buy the base asset on or before the expiration date at an agreed-on price. Put option confers the holder the right, but not the obligation to sell the underlying asset on or before the expiration date in accordance with the style of the options contract (depending on the style of option) for a specified price. Each option contract is a legally binding agreement between two counterparties. On the one side is the buyer of the option who, in accordance with the legal terminology, takes “long position.” On the other side of the agreement is the seller (issuer) who issues the option and takes the so-called “short position.” The seller normally receives from the buyer a specific monetary compensation, named “premium” for the underwriting; at the same time he takes in practice unlimited risk of adverse price movements of the underlying asset.
The pre-agreed price, at which the base asset can be purchased or sold, is called “strike price” (also “exercise price”.) The holder of an American-Style option may exercise his right to sell or buy the asset at any time before the expiration date. The European-Style option can be exercised only on the expiration date. Options are both exchange-traded and OTC traded financial instruments. They are suitable for hedging and speculative purposes in both upside and downside price movements of the underlying assets by diverse options trading strategies.
When an investor determines a particular type of risk can affect his business, he may decide to protect himself against the particular risk by becoming a party to options contract. A European importer of goods from the United States, apprehending of eventual rise of the dollar and increased delivery costs, could decide to fix the U.S. Dollar to EUR buying a call option. Let us assume that the U.S. Dollar falls at the date of purchase. In such case, the importer will lose only the premium paid for buying the option. However, if the U.S. Dollar rises steadily, the value of the option will also go up thus compensating the increased value of the delivery denominated in EUR.
An investor, who intends to hedge currency risk, may enter into derivative contract; it leads to financial result, just the opposite of the result generated by the risk. When the market price of the hedged currency falls, the value of the derivative contract increases, and vice versa. Although most participants on the derivative market use these instruments for hedging purposes, the companies frequently trade derivatives for speculation: aiming to generate profits in case of favorable price movements.
Let us assume a Great Britain company expects to receive $ 420,000 after three months and must exchange the US Dollars to Pounds (USD/GBP). The current exchange rate is £ 1 = $ 1.50. The company anticipates revenue of £ 280,000 (420,000¸1.50), but the conversion rate of US Dollar to Pound Sterling may move up or down at maturity. The firm is exposed to an adverse movement of exchange rates during the three-month period, unless it decides to take some measures to hedge the currency risk.
• If the exchange rate at maturity of the obligation is £ 1 = $ 1.60, the revenue in GBP will be only £ 262,500, £ 17,500 fewer than initially expected and the financial result will be a loss as a result of exchange rate impact. If the company finds the risk acceptable, it may do nothing. In case it decides to hedge the potential currency risk, the firm can buy a put option to sell $ 420,000 against GBP at executive price of £ 1 = $ 1.50. This means the seller of the option will need to buy the dollars for £ 280,000.
• If the exchange rate in three months is £ 1 = $ 1.40, the revenue of the company in Pound Sterling will be £ 300,000 (420,000¸1.40), i.e. with £ 20,000 more than expected. This way the company profits as a result of foreign exchange rate movements. In such a situation, the option will expire worthless and the company will lose only the premium paid for the purchase of the option.
Currency options trading are widely used investment tools for management and protection against currency risk and an integral part of numerous innovative investment strategies. Forex options trading makes future risks negotiable; it leads to removal of uncertainty through the exchange of foreign currency risks.
The investors and financial institutions use Forex options trading as insurance against undesired price fluctuations, which in turn leads to more reliable forecasts, lower capital requirements, and higher productivity. Besides, Forex options trading provide protection against currency risk with minimum initial investment and consumption of capital at exceptionally high adaptability of the contractual terms and conditions in accordance with the specific needs of investors. Forex options trading also allows investors to deal with future price expectations, purchasing a derivatives instead of the base security at a very low transaction price in comparison with direct investment in the underlying asset. In addition to hedging currency risks, currency options are also appropriate instruments for exchange-rate speculations.